Scandal shakes fund shareholders

SAN FRANCISCO (CBS.MW) -- Shareholders who thought their mutual fund companies were above reproach had that trust broken Wednesday as several were accused of trading abuses.

The fraudulent practices enriched fund managers at shareholders' expense, according to New York Attorney General Eliot Spitzer.

Fund industry observers were taken aback by the magnitude of Spitzer's allegations.

"I find it absolutely stunning and almost inconceivable that anything like that could possibly go on with any fund firm that has even a hint of value to its reputation," said Jack Bogle, founder of fund giant Vanguard Group and an outspoken fund industry critic.

Four fund families including Bank of America's
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Nations Funds, Banc One
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Janus Capital Group
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and privately held Strong Capital Management were implicated in Spitzer's complaint for helping a hedge fund make trades that bilked tens of millions of dollars from small investors.

No formal charges have been filed against the fund companies, and no fund company has admitted any wrongdoing, but Spitzer said an investigation is continuing.

And while the allegations are shocking, to be sure, individual investors shouldn't rush to dump their funds, industry watchers say.

"I don't think anybody needs to sell just because of this," said Roy Weitz of Fund Alarm, an online industry watchdog. "All of the shenanigans these fund companies have allegedly engaged in are reflected in the price of the funds."

A key question, Weitz added, is an ethical one. "Investors have to decide if that's the kind of fund company they want to do business with," he said.

The $40 million settlement that Spitzer's office reached with hedge fund Canary Capital Partners LLC cast an unfavorable light on two profit-making schemes that allegedly occurred with the cooperation of the fund families and an intermediary.

Both schemes breached the fund companies' fiduciary duty to shareholders in exchange for substantial fees and other income for themselves, Spitzer alleged in a detailed 44-page complaint.

One scheme involved Canary's "late trading" of mutual fund shares, allegedly through an agreement with certain financial institutions including Bank of America. As described in the complaint, orders received after the market's 4 p.m. Eastern close received that day's price, in violation of securities laws. A fund's price, or net asset value, is calculated once each day at the market close. Orders placed later are supposed to be filled at the following day's closing price.

But the late-trading deal Spitzer outlined enabled Canary to take advantage of market-moving events occurring after the close. Canary apparently could buy and sell hundreds of funds, in addition to the Nations Funds. And a pact with an intermediary, administrative services firm Security Trust Company, gave Canary late trading capacity as late as 9 p.m. Eastern. Spitzer likened the practice to "betting today on yesterday's horse races."

"The late-trader's gain is the long-term investor's loss," Spitzer noted in the complaint.

"This is a 'go to jail' accusation; this is not a slap on the wrist," said Louis Harvey, president of Dalbar, a financial-services market research firm in Boston that advises fund companies. "I've never seen any infraction of this scale in the fund industry."

In the second scheme, the four named fund companies are said to have permitted market timing of their funds -- trades based on expectations of very-short-term gains -- when their prospectuses specifically assured investors that such practices were discouraged.

The fund companies allegedly received substantial investments into some of their funds in return, enriching assets under management -- and themselves, Spitzer charged.

It's fund shareholders who take a hit when market timers redeem shares and take profits. Fund managers must either sell stock or use cash to meet the redemption, leaving remaining shareholders stuck with the bill for capital gains and trading costs.

"If there were direct violations of rules in terms of late trading, and if there were deals cut on timing that violated internal policies of funds that were designed to protect investors, then we wholeheartedly support the regulatory effort to identify and punish the offenders," said Paul Haaga, Jr., chairman of the Investment Company Institute, an industry trade group in Washington, D.C., and a senior executive with the American family of funds. "There's no way the industry condones that."

Many fund companies, to their credit, try to keep fund timers out by charging redemption fees for short-term holdings and in extreme cases, simply not taking a timer's money. But the complaint names several Janus funds, including its Worldwide
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Mercury
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and High-Yield
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portfolios, as being made available to Canary's market-timing bid.

In separate statements, all four companies said they were cooperating with the New York State Attorney General's office.

Geoff Bobroff, a fund industry consultant, said, "This is raising the inherent conflicts that exist in the industry, with the manager making sure that he benefits even though there might be some diminishment of value to their investors."

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